Budget 2011: Income tax to fall next year but future less rosy

Chancellor George Osborne said today that he will cut income tax in a year by increasing the personal allowance but he will implement an effective tax hike from then on.

The allowance will rise by £630 in the 2012/13 year from £7,475 to £8,105 for under-65s which is expected to take 220,000 people out of paying tax altogether.

This will mean an additional £126 in the pocket of a basic rate taxpayer. The personal allowance is the amount of your salary on which you pay no tax.

Those who earn more than £100,000 see the allowance drop by £1 for every £2 of income so the benefit to them of the £630 increase is either reduced or nil (see the Tax Code Checker).

But the good news is tempered by the announcement that from April 2012, many income tax thresholds will rise every year in line with the Consumer Prices Index inflation measure which tends to be lower than the current Retail Price Index measure that is used for rises.

The upshot is that allowances will rise more slowly which is an effective tax rise as less of your income will be tax-free or in a lower band.

These thresholds include the level over which you pay 40% higher rate tax (currently £43,875) and the £150,000 level above which you pay 50% tax.

The personal allowance, however, will only start rising by CPI from £8,105 in April 2013.

The exception is that personal allowances for pensioners (£9,940 for those 75-74 and £10,090 for those aged 75 and over from April) will still rise by the RPI rate for the foreseeable future.

Why does this mean you'll pay more?

Say you earn £10,000 in 2012/13 and 2013/14.

The personal allowance in 2012/12 will £8,105. Say it increase in line with a 2% CPI rise to £8,267, rather than a 3% RPI rise to £8,348, you would pay £16 more tax.

This is because under the smaller CPI interest you are left with £1,733 of taxable income, compared to what would have been £1,652 using the RPI rise.

Martin Lewis, MoneySavingExpert.com creator, says: "This is a cut-down version of raising taxes through fiscal drag.

"That's not George Osborne covered in lipstick – it's the fact that even if you don't raise rates due to either inflation or earnings increases (as is still typically happening) more people end up paying higher taxes anyway.

"The good news is they are thankfully still increasing thresholds, but now in line with the lower, less representative CPI rate of inflation which doesn't include housing costs, so compared to increasing thresholds with RPI people will likely pay more."

50% tax to stay – for now

Osborne also stated that while the 50% top rate tax bracket is temporary, he cannot axe it yet.

He said: "Now is not the right time to remove it as we are all in this together but it's sensible to see how much revenue it raises. I've asked HMRC to find the truth when the self assessment forms come in."

Many taxpayers are already bracing themselves for rises next month.

While the allowance is rising from £6,475 to £7,475 on 6 April which will mean cuts for many, the level at which people pay higher rate (40%) tax will drop from £43,875 to £42,475 at the same time, meaning about 750,000 people will pay higher rate tax that previously paid the basic 20% rate.

In addition, everyone will pay an additional one percentage point in national insurance contributions from April.

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